How to Value Cash Flows

Go beyond simple value screens to find true bargains.

Charlie Munger often says that to the man with only a hammer, everything looks like a nail. For brute force, you can't beat it -- but good luck if you need to fasten a nut and bolt.

Similarly, I've realized that value investors who follow dogmatic rules are no better than the one-tool toolbox. For example, I often want to look only for companies with great balance sheets and ample growth prospects that trade at less than 10 times free cash flow. However, stocks rarely fit into this nice, neat box. So over the years, I've missed out on some pretty great investments, including Whole Foods (NYSE:WFMI), Starbucks (NYSE:SBUX), and MasterCard (NYSE:MA).

As a result, I've been searching for ways to fill up my investing toolbox. For a value investor, that means looking more closely at how to value cash flows.

What is free cash flow?Believe it or not, as a common-stock holder, you are last in line to get paid. Let's say an apparel manufacturer sells $100 million worth of clothing. What does it do with the cash? Basically, the company pays it out, based on priority.

Operational expenses get paid first, because if you don't pay the people who keep your business running, it won't be running much longer. So the first part of the money goes out to suppliers, employees, truckers to transport the clothes, newspapers and television stations for advertisements, and auditors to audit the books.

Next in line are debtholders (and preferred-stock holders), such as banks and bond investors. How much they get depends on many factors, including prevailing interest rates, the structure of the debt, and the credit rating. Generally, investors look at the spread between the rate a company has to pay versus the yield on long-term Treasury securities. The better your credit is, the less risky you are, so the lower the spread becomes.

Then come the holders of common stock. For being the last in line, they get everything that's left over. So the key question is how to value those leftover cash flows. The following is a list that isn't meant to be comprehensive but should be a good starting point.

Treasury yieldsBecause Treasury bonds have virtually no credit risk, they are the benchmark against which all other investments must be compared. If a company with no growth prospects trades at a 5% free cash flow yield and Treasuries yield 6%, then it doesn't make sense to risk more to earn 5% rather than earning a liquid, risk-free 6%.

PredictabilityThe more predictable a company's future cash flows are, the more they're worth. For example, how much would you pay for $100 of debt Bill Gates owed, to be paid in one year? Maybe you'd pay $93, which would give you a 7.5% yield (100/93). How much would you pay for that same $100, but instead to be paid by former Enron CFO Jeffrey Skilling? You might not be sure you'll be able to collect, so you might be willing to pay only $50 or less for that same future cash flow.

Thus, the more predictable a cash flow is, the higher its value. Warren Buffett has made billions of dollars making big bets on companies such as American Express (NYSE:AXP) and Coca-Cola (NYSE:KO) partly because he knows their future cash flow is extremely predictable and thus extremely valuable.

Ability to monetizeThis ties in to the previous point. Companies often get cash flows from different sources, so if a company can find someone who'll pay a fixed amount up front for the right to receive the future flow of money from a particular source, then estimating the value of that cash flow is much easier. A cash flow that can be sold for a lump-sum payment is also known as a "monetizable" cash flow.

The key here is that many investors often value all of a company's cash flows at a single rate. However, doing so can be a big mistake, because cash flows from different sources can be monetized at different rates.

For example, Marriott (NYSE:MAR) figured out a long time ago that investors were valuing all of its cash flows as if everything came from its hotel operations. However, because the company owned its own real estate (at the time), it was in effect paying real estate rent to itself. Marriott executives believed that because the company's real estate was a more solid, dependable asset than its hotel operations, these real estate cash flows should be valued more highly than its operational cash flow.

To address this disparity, Marriott effectively split itself into two companies. Marriott kept its hotel-operations business but spun off its real estate holdings into the company now known as Host Hotels & Resorts (NYSE:HST) and simultaneously negotiated leases with Host. As a result, Marriott kept the cash flow from its hotel operations, while Host earned cash flow from its leases with Marriott. Aside from getting a tax break as a REIT, Host's cash flows were also viewed as more stable and were therefore valued more highly. Marriott thus monetized its undervalued real estate cash flows at a higher rate and increased the total corporation's value.

This monetizing can happen in many ways. Many hotel companies, including Hilton, are converting to asset-light structures in which their real estate capital gets monetized and recycled into franchised operations, thus creating a higher margin -- more predictable cash flow that Wall Street prizes more greatly.

Other retailers do sale-leasebacks, in which the real estate cash flow is monetized at a higher value and reinvested into operations. In addition, some investors are talking about splitting off casino real estate cash flow from the gambling cash flow, which could explain why private equity is so active in the space.

A lot of other factors go into valuing cash flows, including timeline, growth, and terminal value. Thus, it's a good idea to get a better feel for how free cash flow should be valued from different sources for different companies, so as to increase your investing versatility.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.